Trumpcare may be on the backburner, but segments of health care seem poised to outperform in the near term, while long-term trends offer major tailwinds.

Now that the U.S. House of Representatives has moved to shelve the American Health Care Act (AHCA), how should investors position themselves regarding U.S. health care stocks?

After years of strong performance, health care stocks suffered setbacks 2016, due to a combination of drug pricing uncertainty and a broader market rotation from growth to value sectors as the “old economy” recession ended and cyclical areas such as materials and industrials rebounded sharply.

In fact, last year health care underperformed every other sector, prompting investors to lighten up on their exposure. Health care mutual funds experienced record outflows as well, and institutional investors recently had their lowest weighting to the sector in five years.

Health Care Underperformed All Other Sectors in 2016
(S&P 500 Total Returns by Sector as of Dec. 30, 2016)

Manage your Wealth

Find a Financial Advisor, Branch and Private Wealth Advisor near you

Enter zipcode

*Invalid zipcode

Yet, attractive valuations combined with long-term demographic trends suggest that investors should give health care a second look. Even after an early-2017 recovery—the sector was already up 8.5% last week before the AHCA was pulled and has been trending higher ever since—health care is still trading below its historic norm.

“Apart from the financial crisis, health care stocks haven't seen these kinds of valuations in five years," says Dan Skelly, head of Morgan Stanley Wealth Management's Equity Model Portfolio Team. “Investors need to be selective, but we are overweight this key sector in our U.S. model portfolio, which was recently 17% health care versus 14% for the S&P 500."

While the sector may still see its share of volatility post Trumpcare—and given lingering uncertainty over the direction of drug pricing—current valuations may offer investors a margin of “safety.”

Short-term Risks and Rewards

Health care's turn for the worse began in late 2015 after Hillary Clinton commented on one drug maker's extreme price increase. “Price gouging like this in the specialty drug market is outrageous," she tweeted. “Tomorrow I'll lay out a plan to take it on."

“It was the first shot across the bow, but health care remained in the hot seat throughout 2016," says Skelly, adding that some of health care's decline was also due to a slowdown in earnings growth for biotech, as well as a pronounced rotation from growth to value. “Keep in mind that the sector was very crowded toward the end of 2015," he adds.

Even without a repeal of the Affordable Care Act, the prognosis has been improving for health care stocks. Demographic trends, including an aging population in most developed nations and a growing middle-class consumer in developing nations, bode well for long-term growth. “We’re also seeing improving earnings growth, and expect a rise in mergers and acquisitions as management teams invest for growth,” says Skelly.

Biotech and Pharmaceuticals

Despite near-term pricing risks, drug makers offer some of the most attractive valuations, with forward P/E ratios well below historic trends. Meanwhile, strong track records in research and development, combined with a high degree of intellectual capital, suggest that these entities will endure, regardless of any political fallout.

“Our view is that there is a very limited number of quality players that can specifically address the biggest health issues," says Skelly, adding that biotechnology's paramount role in the U.S. likely gives it some insulation in the face of pricing pressure. “The market cap of the U.S. biotech sector is 4.5x the combined size of all of the world’s biotech sectors combined. This industry is a U.S. competitive advantage and today a lot of these high-quality stocks are now trading at attractive valuations."

Biotech Next 12 Month's P/E Ratio
(As of Feb. 28, 2017)

Device Makers and Med Tech

Although this segment of health care wasn't punished to the same degree as drug makers, valuations are still below their historic norm. For investors interested in tapping into the growth potential of an aging population, equipment and supplies offer potential. The population is not only aging, notes Skelly, but older Americans are focusing more on improving their quality of life with everything from new knees to cardio implants.

Life Sciences Tools & Services

Companies that make equipment to test and improve air and water quality represent just 5% of the health care sector, but this emerging area offers long-term opportunity to investors, says Skelly. Clean air and water are a growing health concern, particularly in developing nations, such as China. Developing nations continue to invest in these areas to help build a safety net as they transition to consumer-driven economies.

Morgan Stanley’s Wealth Management Investment Resources team has compiled a client presentation, “U.S. Health Care Under Trump,” which covers these and other insights in greater detail. If you’re a Morgan Stanley client, contact your Financial Advisor to obtain a copy. If you’re not currently a Morgan Stanley client, use the locator below to find a Financial Advisor near you.

Risk Considerations

Equity securities may fluctuate in response to news on companies, industries, market conditions and general economic environment.

Value investing does not guarantee a profit or eliminate risk. Not all companies whose stocks are considered to be value stocks are able to turn their business around or successfully employ corrective strategies which would result in stock prices that do not rise as initially expected.

Growth investing does not guarantee a profit or eliminate risk. The stocks of these companies can have relatively high valuations. Because of these high valuations, an investment in a growth stock can be more risky than an investment in a company with more modest growth expectations.

Companies paying dividends can reduce or cut payouts at any time.

Because of their narrow focus, sector investments tend to be more volatile than investments that diversify across many sectors and companies.

The indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment.

Disclosures

Morgan Stanley Wealth Management is the trade name of Morgan Stanley Smith Barney LLC, a registered broker-dealer in the United States. This material has been prepared for informational purposes only and is not an offer to buy or sell or a solicitation of any offer to buy or sell any security or other financial instrument or to participate in any trading strategy. Past performance is not necessarily a guide to future performance.

The author(s) (if any authors are noted) principally responsible for the preparation of this material receive compensation based upon various factors, including quality and accuracy of their work, firm revenues (including trading and capital markets revenues), client feedback and competitive factors. Morgan Stanley Wealth Management is involved in many businesses that may relate to companies, securities or instruments mentioned in this material.

This material has been prepared for informational purposes only and is not an offer to buy or sell or a solicitation of any offer to buy or sell any security/instrument, or to participate in any trading strategy. Any such offer would be made only after a prospective investor had completed its own independent investigation of the securities, instruments or transactions, and received all information it required to make its own investment decision, including, where applicable, a review of any offering circular or memorandum describing such security or instrument. That information would contain material information not contained herein and to which prospective participants are referred. This material is based on public information as of the specified date, and may be stale thereafter. We have no obligation to tell you when information herein may change. We make no representation or warranty with respect to the accuracy or completeness of this material. Morgan Stanley Wealth Management has no obligation to provide updated information on the securities/instruments mentioned herein.

The securities/instruments discussed in this material may not be suitable for all investors. The appropriateness of a particular investment or strategy will depend on an investor's individual circumstances and objectives. Morgan Stanley Wealth Management recommends that investors independently evaluate specific investments and strategies, and encourages investors to seek the advice of a financial advisor. The value of and income from investments may vary because of changes in interest rates, foreign exchange rates, default rates, prepayment rates, securities/instruments prices, market indexes, operational or financial conditions of companies and other issuers or other factors. Certain information contained herein may constitute forward-looking statements. Estimates of future performance are based on assumptions that may not be realized. Actual events may differ from those assumed and changes to any assumptions may have a material impact on any projections or estimates. Other events not taken into account may occur and may significantly affect the projections or estimates. Certain assumptions may have been made for modeling purposes only to simplify the presentation and/or calculation of any projections or estimates, and Morgan Stanley Wealth Management does not represent that any such assumptions will reflect actual future events. Accordingly, there can be no assurance that estimated returns or projections will be realized or that actual returns or performance results will not materially differ from those estimated herein.

This material should not be viewed as advice or recommendations with respect to asset allocation or any particular investment. This information is not intended to, and should not, form a primary basis for any investment decisions that you may make. Morgan Stanley Wealth Management is not acting as a fiduciary under either the Employee Retirement Income Security Act of 1974, as amended or under section 4975 of the Internal Revenue Code of 1986 as amended in providing this material.

Morgan Stanley Smith Barney LLC, its affiliates and Morgan Stanley Financial Advisors do not provide legal or tax advice. Each client should always consult his/her personal tax and/or legal advisor for information concerning his/her individual situation and to learn about any potential tax or other implications that may result from acting on a particular recommendation.

This material is disseminated in Australia to "retail clients" within the meaning of the Australian Corporations Act by Morgan Stanley Wealth Management Australia Pty Ltd (A.B.N. 19 009 145 555, holder of Australian financial services license No. 240813).

Morgan Stanley Wealth Management is not incorporated under the People's Republic of China ("PRC") law and the research in relation to this report is conducted outside the PRC. This report will be distributed only upon request of a specific recipient. This report does not constitute an offer to sell or the solicitation of an offer to buy any securities in the PRC. PRC investors must have the relevant qualifications to invest in such securities and must be responsible for obtaining all relevant approvals, licenses, verifications and or registrations from PRC's relevant governmental authorities.

If your financial adviser is based in Australia, Switzerland or the United Kingdom, then please be aware that this report is being distributed by the Morgan Stanley entity where your financial adviser is located, as follows: Australia: Morgan Stanley Wealth Management Australia Pty Ltd (ABN 19 009 145 555, AFSL No. 240813); Switzerland: Morgan Stanley (Switzerland) AG regulated by the Swiss Financial Market Supervisory Authority; or United Kingdom: Morgan Stanley Private Wealth Management Ltd, authorized and regulated by the Financial Conduct Authority, approves for the purposes of section 21 of the Financial Services and Markets Act 2000 this material for distribution in the United Kingdom.

Morgan Stanley Wealth Management is not acting as a municipal advisor to any municipal entity or obligated person within the meaning of Section 15B of the Securities Exchange Act (the "Municipal Advisor Rule") and the opinions or views contained herein are not intended to be, and do not constitute, advice within the meaning of the Municipal Advisor Rule.

This material is disseminated in the United States of America by Morgan Stanley Smith Barney LLC.

Third-party data providers make no warranties or representations of any kind relating to the accuracy, completeness, or timeliness of the data they provide and shall not have liability for any damages of any kind relating to such data.

This material, or any portion thereof, may not be reprinted, sold or redistributed without the written consent of Morgan Stanley Smith Barney LLC.

Please be advised that the selection of the Financial Advisors presented to you is done randomly and is based solely upon areas of focus that have been selected by the Financial Advisors themselves and upon their stated preferences or interests. Morgan Stanley makes no representation as to an individual Financial Advisor�s experience and/or knowledge in the stated preferences or interests they have chosen. The preferences and interests that they have chosen have not been vetted by Morgan Stanley. Individuals are encouraged to consider their own unique needs and/or specific circumstances when selecting a Financial Advisor.